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Combining Value And Momentum In Stock Selection And Market Timing

By Jack Vogel, Ph.D. Recently, we wrote two posts about how to combine Value and Momentum for stock selection purposes ( Part 1 and Part 2 ). We followed this piece with a post on combining value and momentum for market timing purposes. In this post, we review the use of combined Value and Momentum for both stock selection and market timing. First, let’s examine the combination of Value and Momentum in stock selection. A concept that has been around for many years . Setting Up a Value and Momentum Portfolio First, let’s set up the experiment. We will examine all firms above the NYSE 40th percentile for market cap (currently around $1.8 billion) to avoid weird empirical effects associated with micro/small cap stocks. We will form the portfolios at a monthly frequency, with a 3-month holding period – so we use overlapping portfolios, a la Jagadeesh and Titman (1993) . We focus on the following 2 variables: Momentum = Rank firms on three momentum variables: 3-month, 6-month, and 12-month momentum. The average of the 3 ranks is the “momentum” rank. Value = Rank firms on three value variables: EBIT/TEV, Book-to-Market (B/M), and E/P (inverse of P/E). The average of the 3 ranks is the “value” rank. Every month, we select the top 100 Value stocks and the top 100 Momentum stocks (and hold them for 3 months). We then equal-weight the holdings. Value and Mom EW (net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. SP500 = S&P 500 Total return. LTR = Total Return to Merrill Lynch 7-10 year Government Bond Index. RF = Total Return to Risk-Free Rate (U.S. T-Bills). Results are net of a 1.00% annual management fee and 2.00% annual transaction costs. Index returns (S&P 500, LTR, and RF) are gross of any fees or transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Results (1/1/1964-12/31/2014): (click to enlarge) The results are hypothetical results, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Takeaways: Combining Value and Momentum outperformed the market (after fees) over the past 50 years. However, the Value and Momentum portfolio does have larger drawdowns and higher volatility than the passive index. On a risk-adjusted basis, the combination value/momentum portfolio is favorable. Interesting, but active equity strategies have drawdown problems As previously discussed , we can examine what happens when we overlay a timing signal on top of the combination value and momentum stock selection system outlined above. Below, I describe the two market timing rules: Valuation-Based Signal: We use 1/CAPE as the valuation metric, or the “earnings yield,” as a baseline indicator; however, we adjust the yield value for the realized year-over-year (yoy) inflation rate by subtracting the year-over-year inflation rate from the rate of 1/CAPE. h.t., Gestaltu . A higher real yield spread is better than a low real yield spread. To summarize, the metric looks as follows if the CAPE ratio is 20 and realized inflation (Inf) is 3%: Real Yield Spread Metric = (1/20)-3% = 2% Some details: The Bureau of Labor Statistics (BLS) publishes the CPI on a monthly basis since 1913; however, the data is one-month lagged (possibly longer). For example, the CPI for January won’t be released until February. So when we subtract the year-over-year inflation rate from the rate of 1/CAPE, we do 1-month lag to avoid look-ahead bias. We use the S&P 500 Total Return index as a buy-and-hold benchmark. 80th Percentile Valuation-based asset allocation: Own stocks when the valuation < 80th percentile, otherwise hold risk-free. In other word, get out of the market if the real yield spread metric is extreme. Momentum-based signal: Long-term moving average rule on the S&P 500 (Own stocks if above 12-month MA, risk-free if below the 12-month MA). Using the Combination Signal: Both signals are calculated using S&P 500 data (Momentum and Valuation). However, if the signals say we should be invested in stocks, we are invested in the Value and Momentum portfolio. Results of all portfolios are net of a 1.00% annual management fee and 2.00% annual transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Results (1/1/1964-12/31/2014): Here we show the results to 4 portfolios: Value and Mom EW (net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. Value and Mom EW (Value RM - net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Valuation-based market timing rule applied: Own stocks (Value and Momentum portfolio) when the valuations aren't extreme, otherwise hold risk-free. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. Value and Mom EW (MA RM - net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Momentum-based market timing rule applied: Own stocks (Value and Momentum portfolio) if they are above the 12-month MA, own risk-free if below the 12-month MA. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. Value and Mom EW (Value and Mom RM - net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Valuation and Momentum-based market timing rules are applied, each having a 50% signal weight. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. (click to enlarge) The results are hypothetical results, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Takeaways: Both the Valuation and Momentum-based market timing rules decreased drawdowns (maximum drawdown and sum of drawdowns). Combining the Value and Momentum market timing rules yields the lowest drawdown, as well as the highest Sharpe and Sortino ratios. Conclusion: Combining Value and Momentum appears to work for both stock selection and market timing. One can argue that there are "better" ways to combine Value and Momentum. However, a simple approach (documented above) seems to work, at least historically. There are few caveats that come to mind: The results above are hypothetical, and the future could change. Valuation-based timing is tough (see introduction of that post), and we've cherry-picked a system that happens to work in-sample, whereas others we've tried don't seem to work that well. These systems can drift violently from standard benchmarks (i.e., one needs to be prepared for tracking error). Value and momentum stocks are much more volatile than a passive index and require a disciplined sustainable investor . Let us know your thoughts! Original Post

Do Not Blame China For Your Missed Opportunity To Reduce Risk

I did not predict the epic fall from grace for the S&P 500 SPDR Trust (SPY). There’s a whole lot more to the extreme selling pressure than drama on the Chinese mainland. The reality is that the financial markets had been telegraphing distress in dozens of meaningful ways for months. I’m not likely to add significant risk anytime soon, short of the Fed giving us another Bullard-like moment where rate hikes are off the table and QE is back on the table. In large part, I will take cues from key credit spreads and price ratios like the iShares 7-10 Year Treasury (IEF): iShares iBoxx High Yield Bond (HYG). Some are crediting me with calling the 6-day mini-crash. On the contrary. When I wrote “ 15 Warning Signs Of A Market Top ” on August 18, the intent was to discuss micro-economic (corporate), macro-economic, fundamental and technical reasons for reducing one’s overall allocation to riskier assets. I did not predict the epic fall from grace for the S&P 500 SPDR Trust (NYSEARCA: SPY ). Based on a Relative Strength Index (RSI) level below 17 – based on the fact that we are approaching lows not seen since October’s “ Bullard Bounce ,” one should anticipate a jump higher. Equally compelling? Since the bull market’s inception (3/9/2009), the S&P 500 has only closed in its 3-standard-deviation range (0.13% chance of occurrence) twice. It happened at the tail end of the eurozone sell-off on 10/3/2011; it happened again today, on 8/25/2015. Yes, you’re going to see higher prices in the immediate term. Relief rallies happen. On the flip side, it’d be foolish to think that a jump off of the floor will be enough to restore the bull market uptrend. Institutions, private clients and hedge funds will need to shift from net sellers to net buyers; they were net sellers in July and August . The pattern of decreasing revenues and decreasing dividends at corporations will need to show marked improvement. Credit spreads need to stop widening and perhaps begin to narrow, demonstrating greater confidence in borrower creditworthiness. And speaking of borrowing, the Federal Reserve will need to come up with a way to inspire as it raises overnight lending rates. A plan for a one-n-done hike across a six-month span? Perhaps an offer to move at a snail’s pace of just one eighth of a point every other meeting? The media may choose to pin all of the blame on China’s stock market collapse. Indeed, interest rate cuts, trading halts, short-selling bans, currency devaluation, looser lending rules and share-buyer incentives have done little to stop the exodus. Keep in mind, though, Chinese equities via db-X Trackers Harvest CSI-300 A Shares (NYSEARCA: ASHR ) crashed in June and July. The S&P 500 was within 1%-2% of its all-time high less than a week-and-a half ago. It follows that there’s a whole lot more to the extreme selling pressure than drama on the Chinese mainland. The reality is that the financial markets had been telegraphing distress in dozens of meaningful ways for months. The Dow Transportations Average had been sickly since the first quarter earnings season, suggesting that manufacturers were not delivering as many goods for worthwhile profits. By early June, broad-based energy corporations in the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) had climbed off of March lows, but they were still mired in a sector-specific bear that began in late 2014. Equally disturbing, at one point in June, the price-to-book (P/B), price-to-sales (P/S) and price-to-earnings ratios (P/E) for the “median” stock on U.S. exchanges had never been higher. Not even during the delusional dot-com days of 2000. As investors were entering July, troublesome deterioration began occurring in market breadth. The Bullish Percent Index (NYSE: BPI ) for the S&P 500 still showed a bullish reading above 50% (59%), yet less and less S&P 500 components had been forging uptrends. Prominent sectors like the Industrial Select Sector SPDR ETF (NYSEARCA: XLI ) began pushing 8% corrective levels on weak wages and weak manufacturing data. Later in July, foreign developed stocks were dropping precipitously and diverging from the U.S. market, highlighting the fading enthusiasm for euro-zone quantitative easing (QE). And high yield bond distress was a clear indication of credit risk aversion . The point here is, we hadn’t even gotten to August, and the signs of a probable sell-off in U.S. equities had been everywhere. You want to blame the second leg down of the stock market bear in China for everything? Why ignore the first leg? Why dismiss free-falling commodities in the summertime, from oil to copper to base metals? Why act as though the consecutive quarters of decreasing sales and lackluster profitability at U.S. corporations hasn’t mattered? Or the anxiety about Congress and the White House with respect to upcoming budget negotiations? Or the most obvious issue of all – angst over the Fed’s explicit goal of hiking rates as early as September. It follows that I have been discussing a tactical asset allocation shift for several months in my columns. I offered simple solutions, such as a moderate growth investor with 65% growth (e.g., large, small, foreign, etc.)/35% income (e.g., investment grade, high yield, intermediate, long, etc.) shifting to 50% growth (primarily large cap)/25% income (primarily investment grade), 25% cash/cash equivalents. A number of anonymous commenters at sites where financial portals regularly republish my articles demonstrated a remarkable penchant for viciousness. They attacked out-of-context word choices. They slammed the evils of rebalancing through tactical asset allocation as market timing idiocy. Some merely raged against my so-called negativity. Ironically, few could debate the array of well-researched and well-presented data – fundamental, technical, micro-economic (corporate) and macro-economic information that served as the basis for my recommendation to “sell a few things high” and hold some cash to limit downside loss and prepare for a future “buy lower” opportunity. And therein lies a problem for the complacent among us. The definition of opportunity is relegated to the “buy side.” Why should that be? When there are 30 some-odd reasons for reducing risk compared with a handful of reasons to stand like a possum in the headlights (I gave 15 in the Market Top feature from one week ago ), shouldn’t we embrace opportunities to lock in profits and/or protect our principal? I appreciate the kudos from those who have written – personally or on message boards – to thank me for “getting them out” in the nick of time. But I don’t have a crystal ball. And I did not suggest leaving risk assets altogether. I simply made the case for why the time for target risk allocations or greater-than-normal stock exposure had exited months ago. I’m not likely to add significant risk anytime soon, short of the Fed giving us another Bullard-like moment where rate hikes are off the table and QE is back on the table. I may even sell a bit more into the oversold conditions that are likely to bring about relief rallies. In large part, I will take cues from key credit spreads and price ratios like the iShares 7-10 Year Treasury (NYSEARCA: IEF ): iShares iBoxx High Yield Bond (NYSEARCA: HYG ). If the IEF:HYG price ratio is declining, a preference for risk-taking would be increasingly evident. That’s clearly not the case today. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at th e ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Liberty All-Star Equity Fund: Making It Harder To Grow?

USA started the year off on a weak note. The second quarter showed notable improvement. But the big news this year is a distribution change. Liberty All-Star Equity Fund (NYSE: USA ) is a unique closed-end fund, or CEF, in that it brings together five different managers in one fund. The goal is to create a so-called core fund that can provide investors with broad market exposure. That’s a great story, but there are other things to consider here… like the recent change to the dividend policy. A different approach Most CEFs take a single approach to investing in equities. And most CEFs have a single team running the show. USA deviates from this , employing five different asset managers to handle the investing with three using a value approach and two focused on growth. It’s kind of like a fund of funds approach, with each asset manager getting roughly equal portions of USA’s portfolio to run. USA’s management, meanwhile, is watching over the individual asset managers to make sure they are doing a good job for shareholders. For an investor looking for a way to get broad equity exposure without having to do much work there are some structural things to like in this fund. An up and down year That said, this hasn’t been the best year for USA so far. For example, the fund’s NAV return was slightly negative in the first quarter and up only about 1% in the second . Through the first six months, then, the fund was up around 0.75%. To be fair, the S&P 500 was up only about 1.25% over the same span. While on a percentage basis USA lagged greatly, on an absolute basis it didn’t. It’s worth noting that, over the long-term, this isn’t out of line. USA has historically lagged behind the S&P based on NAV total return, which includes distributions. For example, over the trailing 15-year period through June the CEF’s annualized NAV return was roughly 3.6% while the S&P returned nearly 4.4%. So why buy a fund that lags over time? In the case of USA, the answer is likely the distribution. The fund started the year with a 6% of NAV annual distribution target. For income investors that would easily beat the yield offered by the S&P in recent years. Add in the fund’s trailing 3-year discount is nearly 12% and the yield a USA investor gets is even higher than the 6% target. For reference, the 10-year average discount is around 11%, according to the Closed-End Fund Association . But wait, there’s more! That, however, was the distribution goal at start of the year. In March the fund kicked that up to 8%. The reason for the change was to ” better align ” the fund’s distribution policy with historical market returns. While that may, indeed, be true, distributing more assets makes it harder for a fund to grow its net asset value. In other words, USA may have just made life more difficult for itself. That said, over the last five years, destructive return of capital hasn’t been a big issue. But with the distribution bump, you’ll want to keep a closer eye on this going forward. If the market turns south, as it has lately, USA may have little choice but to dip into capital to meet its target. On the plus side, the target is actually 2% of assets per quarter, which will by design fluctuate up and down with the fund’s NAV. In the end, 8% may work just fine. I simply wouldn’t want to let this change go unwatched. Why do it? USA’s current discount to NAV is roughly 15%. It’s been hovering around this level all year after trading at a narrower discount most of last year. And an even narrower discount the year before that. With the discount widening, it’s possible that the distribution boost was an attempt to attract investors to the fund and, thus, narrow the discount back toward its historical levels. That’s a cynical view of things, but this is a tactic often used in the CEF world. The problem is that upping the distribution to gain investor attention can be a counter productive move if it ends up making the NAV shrink over time. That said, USA isn’t a bad fund, it’s just not a really good one. If you are looking for a core fund that spits out a decent income stream, though one that fluctuates over time, you should put USA on your watch list. And with a wider than normal discount, it’s not a bad time to take a look. But you’ll want to pay attention to what the distribution change does to the fund. The higher yield may come with strings attached. And for long-term holders, you’ll want to keep a closer eye on the fund over the next few years. A 25% boost in the distribution may feel nice right now, but it will feel awful if it starts to hamper the fund’s performance. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.